Corporate Finance

Estimation of Cost of Capital 
 97

The Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the weighted average of costs of various sources of finance.

WACC = Ke [E/V] + Kd (1 – T) [D/V] + Kp [PS/V]

where
Ke= cost of equity,
Kd= pre-tax cost of debt,
Kp= cost of preferred stock, and
T= tax rate.

E, D, and PS are the amounts of equity, debt, and preferred stock in the capital structure.

V = Market value of all securities (E + D + PS)

Note that the weights used in WACC calculation are target, market value weights and not book value
weights. Market value reflects the value of the firm better than the book value. Book value reflects the
historical value of assets in place whereas market value reflects the value of both assets in place and present
value of future growth opportunities. Moreover, securities are issued at market values and not book values.
Further, the proportions are the target proportions the company intends to maintain. The concept of target
capital structure will be taken up later. The weighted average cost of capital is the hurdle rate to be applied
to projects that have similar risk characteristics (and financing) as the firm. That is, investments should earn
the hurdle rate to meet investors’ expectations. Otherwise investors will be worse off.

An Illustration

Infosys Technologies stock had a beta of 1.48 in 1998. The prevailing long term T-bond rate was 12.15 percent.

Plugging a market premium of 10 percent, the cost of equity for Infosys works out to be:

12.15 + 1.48(10) = 26.95 percent

Infosys does not have debt in its capital structure. So cost of capital and cost of equity are the same. The

WACC for the company during 1995–98 is given in Exhibit 4.8.

Exhibit 4.8 WACC for Infosys Ltd

1998 1997 1996 1995

Rf 12.15 13.6 14.0 14.0

Rm – Rf 10.0 10.0 10.0 10.0

β 1.48 1.48 1.48 1.48

Cost of equity 26.95 28.40 28.80 28.80

Post tax 7.7 7.7 7.7

Cost of debt

WACC 26.95 27.97 27.36 27.36